Date: 10/2/97 5:31 PM
Here are my comments on the Concept Release. I am also sending a hard copy to
the commission.
Comments of Professor James J. Angel
Georgetown University
on the Concept Release; Request for Comments
File S7-16-97
Summary of Comments:
1. Be careful. The U.S. equity markets are the best in the world, so don*t
mess up a good thing. The reforms suggested in the Release are so broad that
there may be unintended consequences that hurt our markets.
2. Reforms should move in the direction of deregulation, not increased
regulation. There has been a major paradigm shift in thinking about equity
markets. The old view was that *the stock market* was a natural monopoly that
needed to be regulated like an old fashioned utility. Every exchange rule
needed to be approved by the omniscient government. The modern view (reflected
in the passage of NSMIA) is that equity markets are businesses that should be
allowed to compete on a level playing field with a minimum of government
interference.
3. Turning Nasdaq into an auction market would be a mistake. Many of the firms
that list on Nasdaq could easily list on auction markets such as the regional
exchanges, the AMEX, and the NYSE, yet they choose not to. This *market test*
indicates that the complex Nasdaq system (including the ECNs who are an
important part of providing liquidity to the system) is doing something right.
Thus, regulations designed to make Nasdaq more like the traditional exchanges
may deprive firms and investors of something that they are freely choosing now.
4. The standard for new products, new market systems, and new rules should be
*Innocent until proven guilty, not *Guilty until proven innocent.*
Micromanagement of the industry hurts the ability of markets to innovate and
compete. SEC should encourage innovation by approving most innovations
immediately and use its broad power only if it later finds abuses.
5. The SEC should switch to a company-based enforcement model in which firms
themselves decide which markets may trade their stock. The firms themselves have
the proper incentives to monitor the trading in their stock and to decide where
their stocks may trade. Thus, if a firm thought that a particular market
mechanism was harmful to the overall market for its stock, it could withhold its
approval.
Comments of Professor James J. Angel
Georgetown University
on the Concept Release; Request for Comments
File S7-16-97
I commend the Commission for opening a dialog on the important issues raised in
the Concept Release. The Commission rightly recognizes that the changes in
global equity markets are forcing a fundamental rethinking of regulation. The
breadth of the proposed changes in the Release is so large that it makes sense
to open a careful debate on what changes are needed and how the reform process
should proceed.
Rather than provide a tedious response to each of the 143 questions in the
Concept Release, I would like to make a few major points:
1. Be careful of unintended consequences.
We should be proud of the fact that the United States has financial markets that
are the envy of the world. International comparisons of equity execution costs
by Plexus and well as Birinyi Associates show that transaction costs for trading
in the U.S. are among the lowest in the world. Our markets are also experiencing
substantial growth in their efforts to promote international listings.
I believe that one of the main reasons for the success and global
competitiveness of the U.S. equity markets has been that the U.S. has fostered
competition between markets and between market mechanisms for both listings and
order flow.
This success of the U.S. equity markets means that extreme caution should be
used in deliberating changes of the magnitude that discussed in the Release. As
the old adage goes, *If it ain*t broke, don*t fix it.*
In particular, the U.S. has been successful in creating liquid primary and
secondary markets not only for the largest firms, but also for smaller firms.
The rest of the world has been particularly unsuccessful in creating liquid
markets for smaller firms. Most of the second-tier markets that have been
launched in Europe have been unsuccessful, as chronicled by Rasch (1994) and
Bannock (1994). For this reason, the commission should be particularly careful
in deliberating changes that affect Nasdaq.
As a finance professor who has spent a decade studying the nuts and bolts
details of market microstructure, I can attest that the financial markets are
extremely complex. The basic functions of a market seem simple at first glance:
a market matches buyers and sellers and discovers a price. However, buyers and
sellers are acting on the information that they believe they possess, which
makes trading an information game. The market mechanism not only matches
buyers and sellers and produces price information about past trades, but it also
produces information about the willingness of participants to trade again.
Furthermore, in order for market prices to be worth anything, the securities
industry has to produce sufficient fundamental information about the relative
values of various investments. Not only does the market mechanism need to
produce this information, it also needs to disseminate and market this
information in order for it to do any good.
The information that one is willing to trade is valuable price sensitive
information that few investors wish to give away; they naturally seek to execute
their trades in manners that reduce the market impact of their activities. The
information flows that occur in our financial markets are quite complex as a
result.
Because markets are not as simple as they first appear, great caution should be
taken with such major reforms as those contemplated in the Release. While
entered into with the best of intentions, such major changes could easily have
major unintended consequences which could seriously hurt our financial markets.
2. Reforms should move in the direction of deregulation, not regulation of new
entrants.
There have been three noticeable phases of thought about the proper role of the
government in the equity market that have affected government policy. The first
phase was laissez-faire: The primary role of the government was to enforce
contracts and prosecute fraud. This thinking was behind the *hands off* policy
followed by the federal government prior to 1933.
The second phase was one of regulation. Following the stock market crash of
1929 and the ensuing financial convulsions, this second wave of thought was the
intellectual force behind the pivotal Securities Act of 1933 and the Exchange
Act of 1934: The equity market was a den of thieves that had to be watched
carefully by the benevolent regulators. Furthermore, the market itself was a
natural monopoly just like an electric utility, and it had to be watched closely
by the regulators or it would abuse its position.
The third and current phase is one of deregulation. This stage views equity
markets as firms that compete with one another. The goal of the regulator is
not to design the details of the market system, but to allow the forces of
competition to do so. This deregulation phase in the intellectual force behind
the National Securities Market Improvement Act of 1996 (NSMIA) which granted
broad exemptive powers to the Commission.
In order to fully comply with the letter and spirit of NSMIA, the Commission
should be seeking ways of reducing the overall regulatory burden it places on
the industry, not placing increased regulatory burdens on the dynamic
innovators.
3. Turning Nasdaq into an auction market would be a mistake.
One of the great advantages of the U.S. equity markets is that a company has
many choices as to where its stock trades. Depending on whether it meets
listing requirements, a stock could trade in the Pink Sheets, on the regional
U.S. exchanges, on the Nasdaq Small-Cap Market, the AMEX, the Nasdaq National
Market, or the NYSE. Approximately 900 firms that meet NYSE listing
requirements have chosen to stay on Nasdaq rather than list on the NYSE, despite
the well publicized investigations and numerous studies which find higher
bid-ask spreads on Nasdaq. Why? Thousands more could list on the AMEX, which
also has substantially lower bid-ask spreads than Nasdaq. Why? Even more small
companies could list on the auction markets run by the regional U.S. exchanges,
yet comparatively few companies do. These firms appear to be run by
sophisticated CEOs who have access to the best advice that money can buy. The
fact that Nasdaq is passing the market test by attracting thousands of firms
that could easily list on auuction markets is evidence that it is providing
something that the listing firms find valuable.
Rule changes that would turn Nasdaq into another auction market would be a
mistake. Firms that want auction markets with low bid-ask spreads can get them
now. Forcing Nasdaq to become an auction market would deprive U.S. companies of
a choice that they are freely choosing now.
4. The standard for new products, new markets, and new rules should be
*Innocent Until Proven Guilty, not *Guilty Until Proven Innocent.*
Practitioners privately relate to me many horror stories about the length of
time needed to get approval for routine new products and rule changes. To
extend this type of micromanagement to ECNs and newer trading systems would be a
great step backward. I feel that the commission should concentrate on lowering
the regulatory burden on existing exchanges rather than increasing it for new
entrants.
The Release speaks with pride about how the commission has reduced the average
number of days needed to rule on an exchange rule filing from 349 days at the
beginning of fiscal year 1994 to 74 days at the end of fiscal year 1996.
However, this period is still far too long. Regulatory delays hurt the ability
of innovators to provide new financial products, and delays hurt the ability of
the heavily regulated exchanges to respond to competitive pressures.
My recommendation: Go from a *Guilty Until Proven Innocent* to an *Innocent
Until Proven Guilty* standard. Allow all proposed rule changes to go into
effect immediately but retain the power to undo the new rules if it later seems
necessary. This could probably be done within the framework of existing
legislation by expanding the types of rules which can take immediate effect.
5. Let companies decide where their stock may be traded.
The Commission is right to consider the impact of different market mechanisms,
both existing and proposed, on the fairness and quality of markets. Yet the
Commission has limited resources to figure out what type of market structure is
best and to police existing markets. Many of the policy questions that are
raised with respect to market transparency, market fragmentation, and so forth
are subtle and complex issues on which reasonable people, including those
without a direct economic interest, may disagree.
There is a simple proposal eloquently espoused by Amihud and Mendelson, among
others: Let the companies themselves decide where their stock may be traded.
If a company feels that the practices of a given market mechanism are harming
their shareholders, then they could prevent that particular market from trading
their stock. For example, if a company thought that payment for order flow was
wrong, then it could prevent its stock from trading in markets that pay for
order flow. If a company thought that a new market mechanism would fragment and
hurt the market for its equity, it could prevent its stock from trading there.
The companies that issue securities have a vested interest in assuring a fair
and orderly market for their stock. They have greater economic incentives than
government employees to make sure that the trading in their stock is fair and
orderly. The threat of loss of listings would be a great incentive to different
markets to make sure that their markets are fair.
By delegating decisions of market design to the markets and the listed
companies, this proposal would allow the Commission to devote fewer of its
scarce resources to the micromanaging of market mechanisms and to redeploy those
resources in other, more productive areas.